Phillips Curve

Keynesians & the Short-Run Phillips Curve

Phillips (1958, pp.283-299) developed the Phillips Curve, specifically the short-run Phillips Curve (SRPC), after investigating data on the rate of change of money wages and unemployment for the UK economy between 1861-1957. The SRPC posits that there is an inverse relationship between inflation and unemployment. As unemployment falls, inflation rises. Along the y-axis of the Phillips Curve is the rate of change of money wages, along the x-axis is the unemployment rate. Phillips (1958, pp.284-299) found that, for the UK economy between 1861-1957, when unemployment was 5.5%, the rate of change of money wages was 0% and when unemployment was 2.5%, the rate of change of money wages was 2%.

As Keynes (1936, p.276) highlights, Keynesianism was criticized for being “one equation short” in terms of not being able to determine the money wage in an economy where the labour market does not clear. Keynesians adopted the Phillips Curve to ‘close’ the Keynesian model by providing an explanation of wage and price determination (Snowden et al 1994, p.150). Keynesians sought to explain the SRPC through AD. As the economy grows and AD increases, firms hire more labour to produce more goods and, to hire more labour, firms must offer higher money wages. But this increases firms’ costs so firms must raise their prices. Lower unemployment thus leads to higher inflation.

Keynesians pointed to the SRPC to indicate a long-run trade-off between inflation and unemployment (Snowden et al 1994, p.150). In the late 1960s and early 1970s, however, both inflation and unemployment rose (Snowden et al 1994, p.150). “Keynesianism was looking increasingly degenerative” (Snowden et al 1994, p.169). The Keynesian proposition of a long-run trade-off between inflation and unemployment was not matched by the empirical evidence. Keynesianism crumbled and this set the scene for the re-emergence of the Classical school of thought this time in the guise of Monetarism.

Monetarism & the Adaptive-Expectations Augmented Phillips Curve

Friedman (1968, pp.1-17) augmented the original Phillips Curve with inflation expectations to argue that there is no long-run trade-off between inflation and unemployment. Noting that real wages equal money (nominal) wages divided by the price level:

Friedman (1968, pp.8-10) contends that workers care about real wages, not money wages, because workers care about how much they can actually buy. A higher real wage means workers can buy more, but a higher money wage does not necessarily mean workers can buy more because prices may be too high.

Referring to the long-run Phillips Curve (LRPC) below, at n*, the natural rate of unemployment or non-accelerating inflation rate of unemployment (NAIRU), the rate of inflation is stable. Before n*, unemployment is below the natural rate and there is upward pressure on money wages that leads to inflationary pressure. All along the LRPC the labour market is in equilibrium at a constant real wage. Moving up the LRPC the real wage is constant, a higher money wage is met by a proportionally higher inflation rate.

Friedman (1968, pp.8-10) assumed that workers have adaptive expectations, that is, workers’ expected rate of inflation () is equal to last period’s inflation. Actual inflation could be 2% in period 2 whilst it was 1% in period 1, so period 2’s expected rate of inflation will be 1%. In period 3, inflation expectations are revised upwards and workers expect inflation of 2%. Each SRPC depends on the expected rate of inflation, not actual inflation. After expectations are revised, the SRPC shifts.

On the diagram below, begin in period 1 at point A, actual inflation is 0% and unemployment is n*. The government use expansionary fiscal policy to boost AD and lower unemployment to u’. Because the labour market is in equilibrium, firms must offer higher money wages to tempt more workers into employment, so money wages rise. But to offer higher money wages means firms’ costs rise so their prices rise and actual inflation rises to 2%. Workers suffer temporary money illusion, they misinterpret the higher money wages as higher real wages because expected inflation is whilst actual inflation is . Real wages do not rise but employment falls and the economy moves along the SRPC from A to B. In period 2, workers adapt their inflation expectations upwards so that . Workers now realize that real wages did not rise in period 1 so they demand higher money wages and the SRPC shifts right. Firms cannot afford the higher real wages so they fire some workers, unemployment rises back to n* and the economy moves to C.

Bibliography

Friedman, M., (1968), The Role of Monetary Policy, American Economic Review, 58(1).